Stocks Rally on Fed Taper Talk

The much anticipated Fed Chair Powell speech this week set the market on fire based upon a restating of exactly what investors already expected. It was the 12th day in a row of stock market malaise in the lower portion of our fourth quarter (Q4) resistance zone when Powell came to the rescue. He affirmed that the spat of 75-point rate hikes would step down to a 50-point hike in December. While this axiomatic revelation warranted a more laconic reaction, stocks feigned surprise and rallied more than 3% on the news. As prices rallied and the Fed Chair handled Q&A, Powell hinted that peak inflation had passed, which further thrilled investors that the Santa Claus rally had begun a new leg higher. The Feds favorite inflation indicator, core Personal Consumption Expenditures (PCE) was reported today at an alarmingly high 5%. Historically, the Fed Funds rate hikes continue above the rate of inflation before peaking.  While the Fed rate may not breach the inflation peak of 5.4%, the strong economy and persistently high inflation rate should keep the bias on short term rates moving upward, despite the current rally in bond prices. 

The manufacturing sector has slowed down, but the record backlogs and supply chain delays from the past year are still being worked off. Along with worker shortages, this allows capacity constrained production to continue expanding, slowly. Sporadic dips in Manufacturing PMI sentiment to contraction levels will appear in 2023, but so far it only suggests moderate pain ahead.

The much larger Service sector, encompassing 77% of the economy, continues to expand at a robust rate. Despite inflated prices, consumers have retained enough of the hyper stimulus handouts to foster record cruise ship bookings and record Thanksgiving Holiday shopping. This week’s GDP report highlighted that the majority of spending is being driven by Government handouts (Transfer Payments). The checking accounts and rate of welfare need to be spent down further before the economy becomes financially stressed. No yellow flags here for the economy on revenues.

Today’s economic reports on inflation, spending and jobs all support a buoyant consumer and jobs picture that throws cold water on the growing concern that Fed rate hikes may cause a major recession. New hiring rates are falling, but with 10.3 million job openings and virtually no unemployment, new hires and payroll numbers need to continue falling for most of 2023 before the economy is right sized.

Our forecasts called for a series or rallies in a falling market this year with peaks due in August and early December with lows due in June, October and January/February (2023).  Our price zone for a potential 2-month rally peak in November/December appears to be nearing the upper end of our old time and price target window. While seasonal patterns allow for a Santa Claus rally continuing to year end, we feel conditions are on the verge of being overbought and may confound the new Bullish consensus. December will be a period where some profits can be taken and cash raised before we enter the mid-January earnings season.         

More time and upward price action may be required before the proposed December peak as our short to medium term indicators are far from the overbought readings registered at the last rally high in August. The Fear gage and volatility index indicate some short-term topping action soon, but sentiment from small investors and option traders remain closer to oversold measures than overbought. We’ll stay patient for now holding onto most long positions before becoming more defensive.

From a broader perspective, the catalysts for a new Bull market remain absent. Higher for longer interest rates and inflation suggest equity valuation multiples on discounted cash flows will keep rallies contained. The question is, will earnings contract and by how much while the Fed keeps the Funds rate near 15-year highs? The disparity of institutional S&P 500 Index earnings forecasts is quite large. Consensus forecasts are falling, but at $230 earnings per share (EPS), there isn’t much room on the upside for stocks. On the other hand, some of the major investment houses like JPMorgan and Morgan Stanley are aggressively reducing their profit picture and looking for numbers around $205 and $195 respectively for 2023 EPS. Such negative projections would favor another trip to the mid-3000’s to upper 2000’s as a Bear case scenario before the next Bull market manifests. These Bear case earnings may be too negative as the massive 2021 – 2022 Government stimulus continues to backstop the financial system. Combined with an aging demographic that supports a more fully employed economy, the odds of a deep recession are greatly reduced. Once inflation is cut in half by next summer and talk of recession grows, we would then expect a sustained Bull market to begin.

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